BUZ LIVINGSTON: A tax loophole we should close

Published: Thursday, November 1, 2012 at 06:02 PM.

A few years ago, we worked with a soon-to-be former St. Joe senior executive.

The project included review of their sizable deferred compensation package and, like all deferred compensation, its substantial ordinary income tax liability. Interestingly some deferred compensation, through a tax loophole likely not to be closed anytime soon, is not taxed as ordinary income.

“Carried interest,” a euphemism for hedge fund and venture capital distributions to principals, has the much more favorable capital gains rate (15 percent) rather than the more burdensome ordinary income rate (35 percent).

The logic behind favorable capital gains rates stands to reason. You have to own the investment for a one-year minimum; most importantly, your capital is at risk. Back during Walton County’s real estate bull market, speculators held property for one year to take advantage of lower capital gains rates.

When the music stopped, well, taxes became the least of their worries. Personally speaking, an out of control fire destroyed a timber stand. Not only were the trees I planted ruined; in the interim timber prices plummeted. With any long-term project, your investment often faces multiple hurdles.

Conversely, hedge fund distributions to owners are not at risk; only investors bear that burden. If no profits transpire, then investors are out of luck, not the big Kahunas. Like Fox News, I’m fair and balanced so it does not matter if the recipient is liberal George Soros, sometimes conservative/ sometimes moderate Mitt Romney or my Bronxville, N.Y., cousin. No one in this crew pays ordinary income tax rates on what is arguably deferred compensation.

A few years ago, we worked with a soon-to-be former St. Joe senior executive.

The project included review of their sizable deferred compensation package and, like all deferred compensation, its substantial ordinary income tax liability. Interestingly some deferred compensation, through a tax loophole likely not to be closed anytime soon, is not taxed as ordinary income.

“Carried interest,” a euphemism for hedge fund and venture capital distributions to principals, has the much more favorable capital gains rate (15 percent) rather than the more burdensome ordinary income rate (35 percent).

The logic behind favorable capital gains rates stands to reason. You have to own the investment for a one-year minimum; most importantly, your capital is at risk. Back during Walton County’s real estate bull market, speculators held property for one year to take advantage of lower capital gains rates.

When the music stopped, well, taxes became the least of their worries. Personally speaking, an out of control fire destroyed a timber stand. Not only were the trees I planted ruined; in the interim timber prices plummeted. With any long-term project, your investment often faces multiple hurdles.

Conversely, hedge fund distributions to owners are not at risk; only investors bear that burden. If no profits transpire, then investors are out of luck, not the big Kahunas. Like Fox News, I’m fair and balanced so it does not matter if the recipient is liberal George Soros, sometimes conservative/ sometimes moderate Mitt Romney or my Bronxville, N.Y., cousin. No one in this crew pays ordinary income tax rates on what is arguably deferred compensation.

In 2007, Charles Grassley, Republican Senator from Iowa, aroused the hedge fund industry’s ire by proposing eliminating the “carried interest” exclusion. After they struck back with a vengeance, threatening him with a primary challenge, he backed down.

Hedge funds are not magic but a marketing ploy. Statistically you get the return of S&P 500 with increased volatility. Increased volatility cuts both ways but taking the risk makes no sense. I have nothing against hedge fund operatives (see cousin above). A signature event in my life occurred last St Patrick’s Day at McTighe’s —home of 30A’s finest Reuben. A former Wall Street hedge fund bigwig couldn’t qualify for a tab. His polite argument was sinking fast until I vouched for him… so sweet.

Shrewd tax attorneys can make astute arguments for the carried interest exclusion but they would be wrong. While tax attorneys seldom err, sometimes they do. Mitt Romney’s income from Bain Capital like George Soros’ is deferred compensation. Their capital was never at risk like my timber, Walton County real estate circa 2006 or your stock investments in 2008.

From The Inbox

One of my favorite actuaries, who hails from Bonifay, pondered if rebalancing your portfolio is little more than market timing. No. Market timing means a bet on one sector versus rebalancing where you adjust your portfolio to a predetermined level. If you wanted a 40 percent stock portfolio and the market went down, then you would buy stocks thereby adjusting your portfolio to the 40 percent target. You force yourself to buy low and sell high.